Defaults? Hardly. Muni-Bond Market Awash In Opportunity

Skittish investors have been fleeing the municipal bond markets at a dizzying pace for weeks since a high-profile analyst proclaimed the apocalypse to be at hand.

Political turmoil in state capitals across the U.S. has only served to heighten the sense of financial chaos that has led to record levels of withdrawals from muni-bond funds.

Meanwhile, savvy investors are lurking on the sidelines waiting for an opportunity to pounce.

“The only question the pros have isn’t when will the Chicago Dump and Zoo Revenue Bonds go bankrupt, because they won’t, but how much lower will they fall before I should step in and add them to my portfolio,” bond expert and financial columnist Malcolm Berko noted wryly.

Municipal bonds are particularly popular among wealthy individual investors because the income derived from many classes of these debt securities is tax exempt. Nearly 40% of the $2.9 trillion muni-bond market is held by individual investors, according to the Federal Reserve.

Many of these investors have grown spooked by relentless accounts of state and local fiscal nightmares. And the noisy demonstrations protesting efforts by a handful of Republican governors to scale back union influence at state houses and municipal complexes in Wisconsin, Ohio, Indiana and elsewhere have only added to fears that state and local governments are teetering on a precipice, ready to default on their debt obligations at any moment.

Those fears have taken their toll on mutual funds comprised of municipal bonds. Since banking analyst Meredith Whitney predicted in December that 50 to 100 cities and counties will default on “hundreds of billions of dollars” of municipal bonds in 2011, muni-bond funds have recorded 13 straight weeks of outflows, to the tune of more than $25 billion, according to Lipper FMI.

But bond experts say the concerns leading to these unprecedented withdrawals are almost entirely unfounded.

“Municipal securities are very safe. There could always be a rare municipality for which things get out of hand, but I believe strongly that the scare tactics fail to recognize the way that muni securities are structured,” said Robert Doty, president of AGFS, a Sacramento, Calif.,-based financial research firm that advises state and local governments.

Doty is the author of a soon-to-be published book targeting muni-bond investors titled “The Municipal Bond Investors Little Handbook—How to Tune Out Media Hype and Make Intelligent Bond Investments.”

Doty said the most common classes of municipal bonds among investors – general obligation bonds and traditional revenue bonds – should not be impacted either by budget gaps or pension liabilities, the two current bogeymen of state and local finances.

That’s because government entities have numerous recourses before they are forced to default on their debt, namely cutting expenses and/or raising taxes.

However, “there are some muni bonds that depend upon the performance or private parties, and therefore have greater risks and rewards, but those are not the ones to which the pundits are referring,” said Doty.

Some bond experts believe the demonstrations roiling state capitals throughout the Midwest could ultimately have a long-term positive effect on the muni-bond market if investor psychology is improved by the perception that government spending will be curtailed if union influence is diminished.

In Wisconsin, where the demonstrations began a week ago, newly-elected Republican Gov. Scott Walker is supporting a bill that would significantly weaken the collective bargaining powers of many of the state’s public employee unions. Walker has said the state needs more bargaining flexibility with its public employee unions if Wisconsin hopes to close a projected $3.6 billion shortfall in the next two years.

“All of this back and forth certainly doesn’t make investors feel any better about owning municipal securities, but longer term it’s a positive for the credit strength of issuers,” said Dick O’Brien, an executive vice president with Folger Nolan Fleming Douglas Inc., a Washington, D.C.,-based brokerage firm.

The demonstrations, O’Brien suggested, could serve as “a partial offset (to Whitney’s dire predictions) and it will play out over time.”

In any case, O’Brien said has been fielding calls for weeks from “sophisticated investors” who view the current environment as an “opportunity.”

Berko described the turmoil in the muni-bond markets as “just so much noise and palaver.”

Citing Illinois, which is facing a $13 billion budget deficit, Berko said the interest payments on the state’s debt account for only a fraction of its overall budget “so default is not as serious as many make it out to be.”

What’s more, the state legislature recently approved a series of big personal and corporate tax increases to help cover the shortfall. The tax hikes, while widely unpopular and approved on a temporary basis, support the argument that government entities have measures at their disposal that make it extremely unlikely they will ever have to default on their debt.

But sophisticated muni-bond investors already know this.

“The investing public is scared but the professional investor -- the institutional investor -- knows that the best time to buy is when there's blood on the streets and when the gutters are running red,” said Merko.

“There are some fantastic bargains in Illinois, Indiana, and Ohio, and over a year ago there were plums for the picking in the California muni market, which seems to have cooled off as common sense seeped back into the equation,” he added. “It will happen too in Wisconsin and elsewhere. But meanwhile the big money center banks -- the New York City investment banking firms, the PIMCOs, the Putnams, Nuveens -- and the traders are smacking their lips while all this brouhaha continues.”